Theme 2: The UK economy: performance and policies Flashcards
1
Q
What is economic growth
A
Measure of an increase in real GDP. Referred to as actual economic growth
2
Q
What is gross domestic product (GDP)
A
The total value of goods and services produce in a country in one year
3
Q
What is potential economic growth
A
Measure of the increase in the productive capacity of an economy. (Movement outwards of PPF)
4
Q
Define recession
A
When an economy has two consecutive quarters of negative economic growth
5
Q
What is the difference between nominal and real GDP
A
Nominal GDP is simply the money value of all goods and services produced by a country in one year. Real GDP is the nominal GDP adjusted for inflation.
6
Q
What are purchasing power parities (PPP)
A
PPPs are used to compare GDP in different countries, and take into account the cost of a ‘basket of goods’ that could be bought in each of the countries being compared.
The PPP exchange rate is the rate that equalises the purchasing power of different currencies by eliminating differences in prices between countries.
7
Q
What is gross national income (GNI)
A
Measures income received by a country both domestically (GDP) and via net incomes from overseas
TF… GNI = GDP + (profits from companies operating abroad and income earned from nationals living in foreign countries) - (profits from foreign-owned companies and income earned from foreign nationals living in the country that goes abroad)
8
Q
Limitations of using GDP to compare living standards between countries and over time
A
- Difference in population: it is necessary to calculate GDP per capita
- Differences in rates of inflation: real GDPs must be compared
- How much of the output is self-consumed so does not appear as GDP
- Methods of calculation and reliability of data may differ
- Type of spending by government: is money spent on warfare, or on quality of life issues such as education and health?
- Differences in income distribution
- Differences in exchange rate
9
Q
What is the Easterlin paradox
A
Research suggests that there is a positive relationship between income and happiness up to a certain level of income.
However, once incomes increase beyond that level, marginal gains in happiness fall (Easterlin paradox).
10
Q
Define inflation
A
Inflation is a sustained rise in the general price level.
11
Q
Define deflation
A
Deflation is a sustained fall in the general price level
12
Q
Disinflation
A
Disinflation is a sustained fall in the rate at which the general price level is rising
13
Q
How is the rate of inflation measured in the UK?
A
By changes in the Consumer Price Index (CPI) which is a weighted average of items on which people spend their money.
14
Q
How is the CPI calculated
A
The Living Costs and Food survey collects information from a sample of nearly 7000 households in the UK using self-reported diaries of all purchases.
A price survey is undertaken by civil servants, who collect data once a month about changes in the price of the 7000 most commonly used goods and services in a variety of retail outlets.
Weights are assigned to each item the average household buys. The weights reflect the proportion of income spent on each item in the average shopping basket.
The price changes are multiplied by the weights to give a price index.
The CPI does not include housing costs, such as rent payments and mortgage interest repayments.
15
Q
Limitations of the CPI as a measure of the rate of inflation
A
- It does not include housing costs, which are a significant item of expenditure for most households in the UK
- Some people do not have representative spending patterns and so might experience cost of living rises by more or less than the average shown by the CPI
- Attempts are made to take account of changes in the quality (eg mobile phone) or weight of goods (eg when chocolate bars are made smaller) but inevitably these adjustments may be imprecise.
- The list of 700 representative items is only changed once a year and so sudden changes in spending patterns are not reflected in the CPI.
- There are sampling issues. For example, households might not provide accurate information on their spending, such as understating the amount spent on alcohol. Also, some households might not respond to the survey.
16
Q
What are the 3 main causes of inflation
A
Demand-pull inflation
Cost-push inflation
Growth of money supply
17
Q
When does demand-pull inflation occur
A
When aggregate demand in the economy increases at a faster rate than aggregate supply. More people buying the same amount of goods means prices rise
18
Q
When does cost-push inflation occur
A
When aggregate supply decreases, ie the total costs of production increase. This leads to a rise in the price level and a more general increase in costs across the econmy.
19
Q
Causes of demand-pull inflation
A
- A decrease in interest rates
- A rise in the level of business and consumer confidence
- An increase in government spending
- Exports rising relative to imports
- Depreciation of the exchange rate (increasing demand for exports and reducing demand for imports)
20
Q
Causes of cost-push inflation
A
- A rise in oil prices and/or raw material prices
- A fall in the exchange rate (making imports more expensive)
- A rise in taxes on businesses
- An increase in the minimum wage or in wages generally
- Increased regulations, eg environmental regulations, health and safety, that increase costs
21
Q
What do monetarists believe
A
Some economists (monetarists) argue that the sole cause of inflation is increases in the money supply.
This is associated with an increase in aggregate demand in the economy.
22
Q
Effects of inflation on consumers
A
- For those on fixed incomes (ie those whose wages do not increase in line with inflation - eg students and pensioners): inflation implies that their incomes would fall in real terms.
- For those with savings: if the rate of inflation is higher than the interest rate on savings, the real value of savings will decrease
- For those with loans or mortgages: if the rate of inflation us higher than the interest rate on loans, the real value of those loans will fall, making them more manageable for consumers.
23
Q
Effects of inflation on firms
A
- Fall in exports: if the UK rate of inflation is higher than that of its main trading partners, the UK’s international competitiveness will fall. A firm’s exports became relatively expensive in foreign markets and imports from abroad seem cheap. This tends to worsen the balance of trade.
- Uncertainty: a high rate of inflation might make it difficult for firms to set budgets, which might result in a fall in investment.
- Lower profits: cost-push inflation is likely to cause a decrease in profits, which could result in lower investment. However, some inflation is desirable because it enables firms to increase revenues. In turn their profits could increase (especially if there is demand-pull inflation) and this might encourage them to invest.
- Impact on monetary policy: high inflation rates might cause the Monetary Policy Committee (MPC) to increase interest rates. This is known as tight monetary policy, and can have damaging effects, for example on investment by firms (it falls because the cost of borrowing increases).
24
Q
Effects on inflation on the government
A
- Fall in the real value of the national debt: inflation would reduce the value of the debt owed by the government. Therefore, it becomes less of a burden.
- Increased inequality: inflation might make it more difficult for a government to reduce income inequality because those on fixed incomes will see a fall in the real value of their incomes
- A deterioration in the balance of trade: if inflation causes a fall in the country’s international competitiveness, its exports are likely to fall and imports to increase. This causes a deterioration in the trade balance.
25
Effects of inflation on workers
- For those in a weak bargaining position: if inflation is rising at a faster rate than wage increases, workers become progressively worse off, even if in nominal terms their wages have increased. However, if wages rise faster than inflation then real incomes rise.
- Unemployment: according to some economists there is a short-run trade-off between inflation and unemployment (the Phillips curve). A very low rate of inflation might imply a low level of demand in the economy and a high rate of unemployment.
26
What is the level of unemployment
The number of people in work
27
What is the employment rate
The number of people in work as a percentage of the working age population
28
What are the measures of unemployment
The Claimant Count: this is based on claimants of unemployment-related benefits, either from Jobseeker's Allowance (JSA) or Universal Credit (UC).
The International Labour Organisation and the UK Labour Force Survey: The Labour Force Survey (LFS) is a survey of a sample of households. It asks people aged between 16 and 65 whether they have been out of work over the last 4 weeks and if they are ready to start within 2 weeks... The LFS uses standard international Labour Organisation (ILO) methods of measuring unemployment. Consequently, other countries use this method of measuring unemployment, allowing for international comparison.
29
What are the measures of unemployment
The Claimant Count: this is based on claimants of unemployment-related benefits, either from Jobseeker's Allowance (JSA) or Universal Credit (UC).
The International Labour Organisation and the UK Labour Force Survey: The Labour Force Survey (LFS) is a survey of a sample of households. It asks people aged between 16 and 65 whether they have been out of work over the last 4 weeks and if they are ready to start within 2 weeks... The LFS uses standard international Labour Organisation (ILO) methods of measuring unemployment. Consequently, other countries use this method of measuring unemployment, allowing for international comparison.
30
What is the unemployment rate
The unemployment rate is the number of unemployed people as a percentage of the labour force.
31
What is the labour force
(Economically active population). It consists of the unemployed plus those paid or self-employment.
32
What is underemployment
The Office of National Statistics (ONS) measures underemployment as all those workers wanting to work more hours than they currently do and who are available to start in 2 weeks.
The OECD also includes in the definition of underemployment those people who are working in jobs where their skills are not adequately utilised, ie they are overqualified for the job that they are doing.
33
What does an increase in the employment rate cause
- Increased GDP, ie with higher employment, output in the economy is likely to increase
- Increased revenues and profits for firms
- Increased incomes, leading to an increase in the standard of living for households
- Improved skills (human capital - which is the knowledge and skills of a workforce that determine its productivity) of workers)
- Higher government taxation revenue - as more people pay tax and spend more (VAT and corporation also tend to rise when employment rises)
34
What does a decrease in the unemployment rate cause
Similar to the impacts of an increase in the employment rate but also include:
- Falling government spending on JSA, UC, and other out-of-work benefits
- Increased employment, which can have significant benefits because people who are out of the job market for a long period become increasingly unemployable
- The job market becoming less flexible (with fewer workers for employers to choose from)
35
Define economically inactive
People not in education, employment, or training, and who are not actively seeking work within the last 4 weeks and who are unavailable within the next 2 weeks
36
Impacts of an increase in the inactivity rate
- The productive capacity of the country will fall
- There may be more claims on state benefits
- The dependency ratio will increase (the number of inactive people that active and employed people are supporting, directly or indirectly).
However, if an increase in the activity rate is due to more people in higher education then this is likely in an increase in the skills of the future workforce
37
What are the causes/types of unemployment
Cyclical (or demand-deficient): lack of spending in the economy/recession means that people are out of work. You expect this type of unemployment in a recession.
Structural: where industries are in decline and workers' skills are becoming obsolete (out of date).
Frictional: where people are between jobs.
Seasonal: where people are out of work for some periods of the year, for example ski instructors in the summer and surf instructors in the winter.
Classical or real wage inflexibility: where there are problems with the supply-side of labour, eg the minimum wage is too high and set above the equilibrium wage. Some economists (classical approach) argue that this is the cause of persistent unemployment in some countries.
38
Impact of migration on the economy
- If immigrants come into a country to fill vacancies then immigration leads to an increase in employment
- However, if immigrants are looking for work and either do not find it or displace other people from work then employment may be unchanged and unemployment might increase
- Migration might have implications for public finances - if the migrants find work then they will be paying taxes
- If immigrants come to a country to earn money to send home to their families (remittances) then this will adversely affect the current account of the balance of payments, at least in the short run.
39
What impacts will a highly skilled workforce have on an economy
- The workforce is more productive, so helping to increase the country's rate of economic growth
- Earnings of highly skilled workers are likely to be higher than those of unskilled workers
- Highly skilled workers are less likely to be unemployed and have more stable and secure employment
- The above points mean that income inequality and poverty are likely to be lower than if there was a large proportion of unskilled workers in the economy
40
Effects of unemployment on consumers
- Decrease in living standards
- Loss of confidence leading to lower consumer spending
- Danger of mental illness if unemployed for a long time
- May result in lower house prices and a fall in personal wealth
41
Effect of unemployment on firms
- Easier to recruit new employees
- Less consumer spending so firms face falling sales, revenues, and profits
- Since there is surplus labour in the economy, firms might be able to hold wages down and, therefore, their costs
42
Effect of unemployment on workers
- Loss of skills - workers may not have up-to-date training
- Loss of income - welfare benefits are rarely as generous as paid employment
- Lower living standards because they have less income so quality of life falls
- Long-term unemployment may make it more difficult to get a job in the future
43
Effect of unemployment on governments and society
- Increased spending on welfare benefits, eg UC
- Less revenue from income tax and indirect taxes
- Opportunity cost - the goods and services that could have been produced by the unemployed workers
- Inequality may increase, perhaps resulting in more crime and/or political unrest
44
What is the balance of payments
A record of international payments over the course of a year
45
What is the current account
Records payments for transactions between countries in the present year.
46
Current account =
Balance of trade + the primary balance (investment income) + the secondary balance (current transfers)
Primary balance (investment income): earnings of foreign investments (interest, profits, and dividends) - payments made to foreigners
Secondary balance (current transfers): relates to transfers in the form of money or of goods and services, eg taxes and social security combinations
47
What is the balance of trade
The value of goods and services exported minus the value of goods and services imported
48
When does a current account surplus occur
When more money is flowing into the country than is flowing out... that a country's current account is positive - ie that the combined value of the net trade balance, the net primary balance, and the net secondary balance is positive.
49
When does a current account deficit occur
When more money is flowing out of the country than is flowing in... that a country's current account is negative - ie that the combined value of the net trade balance, the net primary balance, and the net secondary balance is negative.
50
Causes of a current account deficit
- The currency is too strong relative to other countries. For example, if the pound buys many euros then exports of goods and services from the UK will be relatively expensive. Meanwhile imports into the UK will be relatively cheap.
- There is a high rate of inflation relative to other countries
- There are high wage costs relative to other countries
- There is a high rate of economic growth in a country. People have higher incomes and tend to buy more imports from abroad.
51
Causes of a current account surplus
- The currency is too weak relative to other countries. For example, if the yuan is low against other currencies then China's exports will be relatively cheap. In contrast, imports into China would be relatively expensive.
- There is a low rate of inflation relative to other countries
- There are low wage costs relative to other countries
- There is a low rate of economic growth in a country. People have less income to buy imports from abroad. In turn, this creates a strong incentive for firms in the country to export.
52
What is the relationship between current account imbalances and other macroeconomic objectives
If a country has a persistent current account deficit then it might imply that the country's goods are uncompetitive, which could cause an increasing level of unemployment.
In turn, this may lead to a fall in the rate of economic growth. However, this may not be true if the deficit was caused by lower exports associated with a boom in the economy and high levels of consumer expenditure.
It could cause a fall in the country's exchange rate against other currencies. In turn, this would cause an increase in import prices, which could be inflationary.
53
What are global supply chains
These are worldwide networks of companies and their suppliers, manufacturers, warehouses, distribution centres, and retailers. The supply chain involves the acquisition of raw materials which are then transformed, manufactured, and delivered to customers.
54
What is aggregated demand (AD)
AD is the total amount of planned spending on goods and services at a given price level in an economy in a year.
AD = C + I + G + (X - M)
55
What is the relative importance of the components of aggregate demand for the UK
- Consumption = 60% of AD
- Government expenditure = 25% of AD, however during the the 2008 financial crisis and COVID this proportion increased significantly (not least because overall AD fell considerably).
- Investment = 15% of GDP but fluctuates according to the state of the economy
- Net trade is an insignificant element of AD
56
Why is the AD curve downward sloping
- The real balance effect: when the price level rises, the purchasing power of cash assets falls, which leads to a decrease in the demand for real output.
- The international trade effect: a rise in the price level (relative to other countries) causes a decrease in the international competitiveness of UK goods, so causing a decrease in demand for exports and a rise in demand for imports. This results in a contraction in AD, ie a movement up the AD curve.
- The interest rate effect: assuming a constant money supply, a higher price level results in an increased demand for money. As a result, interest rates rise, reducing consumption and investment and so causing a contraction in AD.
57
What is disposable income
The household income available from employment, private pensions, investments, and welfare benefits after direct taxes such as income tax, national insurance, contributions and council tax have been deducted.
Disposable income is the main determinant of consumption
58
What is consumption
Spending by households on goods and services
59
Average Propensity to Consume (APC) =
(Consumption / Disposable income) x 100
60
Average Propensity to Save (APS) =
(Savings / Disposable income) x 100
61
What are other influences on consumption apart from propensity to save and disposable income
Interest rates (the cost of credit):
- If interest rates rise, then the cost of borrowing to consumers increases.
- It also increases the opportunity cost of spending (ie saving) - higher interest rates mean that more money can be earned by leaving money in the bank.
Consumer confidence:
- If householders feel secure in their jobs and their future prospects then they are more likely to buy big-ticket items such as new cars or expensive electrical goods.
- Consequently, what people think is going to happen to the economy has a big influence on the level of consumer expenditure
Wealth effects:
- An increase in house prices or share prices means that householders feel wealthier.
- This encourages people to spend more
- For example, if a house is worth more then then owner might take out a large loan on the house to finance the purchase of goods and services.
- Similarly, if the price of a person's shares go up they might be more willing to book a foreign holiday or spend money on home renovations.
Other factors include: level of employment, welfare benefits, and pensions.
62
Distinction between gross investment and net investment
Gross investment refers to the total expenditure on new capital goods.
Gross investment = net investment + depreciation
Net investment refers to new additions to capital stock after taking into account the fall in value of capital assets
Net investment = gross investment - depreciation
Depreciation refers to the fall in value of a capital asset due to wear and tear and obsolescence.
Net investment is more useful than gross investment as a sign of improvements in the prospects for the economy.
63
What are the influences on investment
The rate of economic growth:
- If there is an increase in real GDP then firms will need more capital in order to meet the increased demand.
- Therefore, an increase in real GDP causes investment to rise, and an increase in investment causes real GDP to rise. This is a virtuous circle.
Business expectations and confidence:
- If firms expect to sell more in the future they are more likely to invest today.
- Similarly, if business confidence is high, eg if economic growth is likely to be sustained, then firms are likely to invest.
Keynes and 'animal spirits':
- John Maynard Keynes coined the term 'animal spirits' to describe the instincts and emotions that may determine whether or not firms decide to invest
- Given the degree of uncertainty in which an economy operates, many decisions about whether to invest are taken as a result of 'animal spirits'.
Demand for exports:
- A significant and sustained increase in demand for a country's goods from abroad is likely to stimulate investment.
- However, some firms are reluctant to export because of the rules, regulations and other difficulties involved in international trade.
Interest rates:
- If interest rates rise, investment tends to fall because it costs more to borrow the money in order to invest.
- However, a rise in interest rates might not deter investment if businesses think it would still be profitable or if they are funding the investment from retained profits.
Access to credit:
- Low interest rates do not necessarily mean that loans are readily available. Banks might not be willing to take risks in their lending. In the aftermath of the 2008 financial crisis, firms often found it difficult to borrow even if they wanted to.
The influence of government:
- Government policy might mean changes in tax rates that directly affect firms.
- For example, if the government decides to cut corporation tax (a tax on profit) then firms are more likely to invest.
Government regulations:
- If the government relaxes planning restrictions, firms are more likely to invest in building projects.
64
What are the influences on government expenditure
The trade cycle:
- The trade cycle refers to fluctuations in GDP around the long-run trend in economic growth.
- During a downturn in economic growth, government expenditure is higher because, for example, expenditure on welfare benefits is higher.
- The government automatically spends more in a recession, as government spending increases on out-of-work benefits.
- The government automatically spends less in a boom, as government spending on welfare benefits decreases.
Fiscal policy:
- Governments may deliberately manipulate total spending in the economy by changing their own level of spending. This is called discretionary fiscal policy.
- Note that the government does not have to 'balance its books' in the short run, meaning that it can spend more or less than it receives from tax revenues.
65
What is fiscal policy
Fiscal policy refers to the use of government expenditure and taxation to influence the level of economic activity
66
Net trade balance =
Value of exports - value of imports
67
What are the influences on the net trade balance
Real income:
- If incomes rise within an economy then there is a reduced incentive for domestic firms to export because they can sell their goods and services in the domestic economy.
- In addition, higher real income leads to an increase in demand for imports, depending on the value of the marginal propensity to import.
Changes in the exchange rate:
- If the exchange rate rises against other currencies, net exports are likely to fall because exports become less competitive and imports become more competitive in the domestic economy.
- However, in the short run a strong exchange rate might increase the value of exports and decrease the value of imports. The reason for this is that the demand for exports and imports is price inelastic in the short run because spending patters do not adjust quickly to price changes.
Changes in the state of the world economy:
- The value of UK exports is heavily dependent on growth rates around the world.
- In 2020, the COVID-19 pandemic caused a global recession, which inevitably resulted in a fall in demand for UK exports.
The degree of protectionism:
- If there are high tariffs (taxes on imports) or other restrictions on trade, firms find it difficult to export to certain countries.
Non-price factors:
- Quality and design
- Reliability
- After-sales service
- Transport costs
68
What is aggregate supply (AS)
The total amount of goods and services that all firms in the economy are willing to supply at a given price level in an economy in a year.
69
Why is the AS curve upward sloping
As when the price level increases, firms in the economy are willing to supply more.
70
What may cause the AS curve to shift upwards or downwards?
If the costs of production rise, the AS curve shifts left (upwards). For example, this could be caused by:
- An increase in oil prices causing a rise in the production costs of firms.
- An increase in employers' national insurance contributions
If the costs of production fall, the AS curve shifts right (downwards). For example, this could be caused by:
- An increase in productivity
- A fall in raw material prices
71
What is the difference between short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS)
SRAS:
- The SRAS curve may be drawn as an upward sloping curve from left to right.
- SRAS assumes that some resources, eg capital equipment, are fixed.
- However, it is possible to use some existing resources more intensively. For example, a car manufacturer faced with increased demand might employ a night shift, so using machinery more fully.
- Therefore, a higher price level might result in an increase in real output.
LRAS:
- The LRAS curve may be drawn as a vertical line, ie it is perfectly inelastic (classical view), or a backward sloping L curve (Keynesian view).
- LRAS assumes that all resources are variable
- In the classical view, a shift in the AD curve has no impact on real output since the AS curve is perfectly inelastic in the long run if the economy is in equilibrium.
72
What is the difference between the classical approach and the Keynesian approach to the economy
In the classical approach, the economy is self-adjusting if markets are free from government intervention. If there is unemployment, wages fall until people can find work and full employment is restored.
In the Keynesian approach the economy may be in equilibrium with unemployment, and governments may need to stimulate AD to achieve long-term growth and employment.
- The Keynesian approach suggests that output can be increased without a significant increase in costs (that is, the AS curve is not vertical). In this case there is spare capacity (or an output gap). This implies that there are unused resources in the economy.
- Therefore, according to the Keynesian view an economy can be in equilibrium and also have spare capacity, ie unemployed resources.
- Consequently, unemployment and recession will not disappear without government intervention.
73
Define spare capacity
Where there are unemployed resources in an economy
74
What are the factors influencing short-run aggregate supply
- Change in the cost of raw materials: if the cost of electricity rises, the cost of production of almost everything also rises, meaning that AS decreases (the curve shifts to the left).
- Change in exchange rates: if the exchange rate of the pound increases in value against other currencies then imports become cheaper and LRAS increases.
- Changes in tax rates: if there is a reduction in employers' national insurance contributions then the costs of firms fall and the SRAS curve shifts to the right.
- Change in the level of tariffs (taxes on imports): if a country increases tariffs on its imports then the costs for domestic firms rise. This causes a leftward shift in the SRAS curve.
75
What are the factors influencing long-run aggregate supply
- Technological advances: new robotics technology, for example, can reduce costs for a broad range of firms, causing a rightward shift in the LRAS curve.
- Relative productivity changes: productivity is defined as output per unit of input. If there is an improvement in productivity, the LRAS curve shifts to the right.
- Education and skills changes: if more people are well educated then LRAS increases.
- Changes in government regulations: if the government introduces laws to reduce environmental pollution that require firms to change technology then the LRAS curve may shift to the left if the laws cause a reduction in the productive potential of the economy.
- Demographic changes and migration: demographic changes have a direct effect on the supply, skills, and cost of labour, and therefore impact on LRAS. For example, if there is an ageing population and a smaller workforce then the dependency ratio will increase and aggregate supply will fall. Migration has a specific demographic effect in that if many immigrants are of working age then LRAS will increase.
- Competition policy: if the government makes new laws to make it easier to set up and run businesses, then LRAS is likely to increase. This is sometimes called a 'cut in red tape' or a 'cut in bureaucracy'.
- Changes in the minimum wage: an increase in the minimum wage can increase costs for firms, meaning that SRAS falls. However, there is evidence that increasing minimum wages can increase the productivity of workers, which might mean that LRAS increases.
76
What is the circular flow of income
National income is the total value of all the goods and services produced by a country in a year.
- The households provide factors of production, eg labour in return for which they receive wages
- People then use their incomes to buy consumer goods and services
Given this circular flow of income, by definition, national income = national output = national expenditure.
77
Define income and wealth
Wealth is the value of the total assets of worth owned by an individual, firm, or country. It is therefore a stock concept and can be measured at a particular point in time.
Incomes is a flow of money received by factors of production, eg wages, rent profit, interest. It is measured over a period of time.
There is a strong correlation between income and wealth. The ownership of wealth generates income such as rent or interest.
78
What are the injections into the flow of income
Injections are additions to circular flow of income:
- Investment (I): an increase in the capital stock (assets)
- Government expenditure (G): when the government spends money to provide goods and services, such as healthcare through the NHS
- Exports (X): when people from abroad buy domestically produced goods and services.
79
What are the withdrawals from the flow of income
Withdrawals are leakages out of the circular flow of income. If money is not re-spent within the economy then it is being withdrawn from the circular flow:
- Savings (S): when people decide to spend money later rather than now it means that there is less spending in the current time period.
- Taxes (T): when the government imposes taxes then money leaks out of the circular flow because it is no longer available to spend by consumers or businesses.
- Imports (M): when goods and services are brought from abroad, money flows out of the country. This means income is withdrawn from the domestic circular flow.
80
What is an equilibrium, and why does it matter in terms of AD and AS
An equilibrium is a balancing point where there is no tendency for the price level or output level to change.
If the price level was higher than the equilibrium point, there would be a tendency for it to fall. This is because AS would be greater than AD.
If the price level was lower than the equilibrium point, there would be shortages and the price level would start to rise in order to make sure that everyone could get what they were prepared to pay for.
81
What is the multiplier
The multiplier shows the amount by which a change in an injection or leakage causes total income to change. It is the result of income being re-spent in the economy, having second round and successive effects. If the injections into the circular flow increase, then there will be a larger final change in GDP in the economy.
Multiplier = (Change in real GDP) / (Change in injections)
82
What are the effects of the multiplier on the economy
- The multiplier causes an injection to have a magnified effect on GDP
- The International Monetary Fund (IMF) has estimated the value of the multiplier in the UK to be between 0.9 and 1.7
- This illustrates that it is not easy to accurately estimate the impact of an injection on the economy. Much depends on, for example, the amount of unemployed resources in the economy.
- A positive multiplier effect of an increase in an injection would cause a rise in GDP, leading to a fall in unemployment and possibly a rise in the rate of inflation if the economy is at full employment.
- The UK's multiplier is relatively low, in part because of its high marginal propensity to import.
- Generally it is expected that the value of the multiplier is higher in developing economies than in developed economies.
83
What is the marginal propensity to consume and what is its effect on the multiplier
The marginal propensity to consume (MPC) refers to the proportion of an increase in income that is spent.
MPC = (Change in consumption) / (Change in income)
The higher the value of the MPC, the higher will be the value of the multiplier and consequently the greater will be the impact of an increase in an injection on GDP.
Multiplier = 1 / (1-MPC)
84
What is the marginal propensity to save and what is its effect on the multiplier
The marginal propensity to save (MPS) refers to the proportion of an increase in income that is saved.
MPS = (Change in saving) / (Change in income)
The higher the value of the MPS, the lower the value of the multiplier. This means that any change in an injection has a smaller impact on the overall level of spending.
Multiplier = 1 / (1-MPS)
85
What is the marginal propensity to tax and what is its effect on the multiplier
The marginal propensity to tax (MPT) refers to the proportion of an increase in income that is taxed.
MPT = (Change in tax) / (Change in income)
The higher the value of the MPT, the lower the value of the multiplier. This means that any change in an injection has a smaller impact on the overall level of spending.
86
What is the marginal propensity to import and what is its effects on the multiplier
The marginal propensity to import (MRM) refers to the proportion of an increase income that is spent on imports.
MPM = Change in imports / Change in income
The higher the value of the MPM, the lower the value of the multiplier. This means that any change in an injection will have a smaller impact on the overall level of spending.
87
What is the significance of the multiplier for shifts in AD
If there is a change in any one of the injections or leakages, the total effect on the economy as a whole will be much greater than the original change.
The multiplier magnifies the impact of changes on the economy as a whole - the larger the multiplier, the greater the impact of any changes in injections or leakages.
The bigger the value of the multiplier, the larger the overall shift in AD. Remember that this can be a magnified increase or a magnified decrease in real national output.
88
What is actual economic growth
Actual growth is the measure of changes in real GDP, found by adding up all the incomes in the country, or all the spending, or all the output.
HE, can be difficult to measure output accurately, as was the case during COVID as many firms that were temporarily closed did not complete surveys.
89
What is potential economic growth
Potential growth shows how much the economy could produce if there was full employment of all the resources in the economy. Potential growth is reflected in changes in LRAS.
The difference between the actual and potential growth is the output gap.
Potential output is determined by the potential size of the labour force, the capital stock, productivity, and discovery of natural resources.
90
What are the factors that cause economic growth
Causes of changes in AD:
- Increase in consumption: caused by, for example, higher real wages or cuts in income tax or increase in value of assets (the wealth effect).
- Increase in investment: caused by for example, increased confidence, lower interest rates.
- Increase in government expenditure: caused by, for example, political priorities.
- Increase in net exports: caused by, for example, depreciation of the country's currency.
Causes of changes in LRAS:
- Increase in investment: for example, in infrastructure.
- New technology: for example, use of robots and artificial intelligence
- Increase in net migration: for example, making it easier for people to immigrate into the country.
- Supply-side policies: these policies would increase productivity.
Conversely, there may be factors that restrict or inhibit economic growth. These might include:
- A lack of access to funds for investment
- Corrupt governments
- Currency instability or an overvalued exchange rate
- Poor-quality human capital
- Protectionism by other countries limiting free international trade.
91
Why is international trade important for export-led growth
International trade is very important for economic growth because an increase in exports causes the AD curve to shift to the right, with multiplier effects.
Export-led growth is economic growth associated with an improvement in the current account of the balance of payments.
In order to stimulate exports, a country might employ the following strategies:
- Engineer a depreciation of the exchange rate (eg by cutting interest rates). This makes exports relatively cheap and imports relatively expensive.
- Adopt policies to improve productivity and efficiency in export markets (eg by providing incentives for investment in new technologies).
92
What is the actual growth rate of economic growth
The rate at which real GDP changes from one year to another
93
What is the long-term trend rate of economic growth
Calculated as the average rate of economic growth over several years. It is determined by the increase in productive capacity and is consistent with a stable rate of inflation.
94
What is a negative output gap
A negative output gap exists when actual growth rates are below potential growth rates.
95
What is a positive output gap
A positive output gap is when growth rates are higher than the economy can sustain, ie higher than the long-term trend rate of growth.
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What are the problems of measuring output gaps
- Output gaps, then, are a sign that the country is not using its resources efficiently, or at their maximum potential.
- In practice, it is very difficult to measure output gaps because of the difficulty of measuring the level of potential output. All that is known is actual output (as measured by real GDP) at a point in time.
The potential level of real output depends on spare capacity, which is very hard to estimate accurately. Reasons include:
- Resources available are not suited to the needs of the economy.
- Production is relocated to other countries
- Structural changes or major shocks to the economy may occur, causing some productive capacity to be permanently lost.
97
Describe the business cycle
- The rate of economic growth rarely stays constant over years.
- Instead, there may be some periods of rapid economic growth (a boom) when the rate of growth is higher than its long-term trend.
- On the other hand, there may be some periods of very slow economic growth (a slump) when the rate of growth is lower than its long-term trend. This could result in a recession (two consecutive quarters of negative economic growth), as occurred in many countries in 2008 and again in 2020.
- Between the boom and the slump there is a slowdown, and between the slump and the boom there is a recovery.
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What are the characteristics of a boom
- Low unemployment
- Less underemployment
- Increasing living standards
- Increased levels of investment
- An increasing rate of inflation - if caused by rising AD
- Increasing income inequality - if associated with rising asset prices
99
What are the characteristics of a recession
- Rising unemployment rates
- More underemployment
- Falling living standards
- Falling levels of investment
- A falling rate of inflation (because AD is falling)
- Increasing income inequality - if associated with higher unemployment
100
What are the benefits of economic growth on consumers
- Economic growth is associated with rising real incomes.
- Consequently, consumers are able to afford more good and services, leading to higher standards of living.
- Higher real incomes may help people to eat more healthily and lead to an increase in life expectancy.
- Some research suggests that higher real incomes lead to an increase in subjective happiness.
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What are the benefits of economic growth on firms
- With higher real incomes and increased demand for goods and services, firms are likely to benefit from increased profits.
- Consequently, shareholders are likely to enjoy increased returns.
102
What are the benefits of economic growth on the government
- During a period of economic growth real incomes will be increasing. This means that government tax revenues are rising, as workers are paying more tax on their incomes, people are spending more so VAT revenues will be rising, and firms will be paying more tax because their profits are higher.
- The government could also use the increased tax revenues to reduce income inequality.
103
What are the benefits of economic growth on current and future living standards
- Economic growth may help to lift people out of poverty
- Developing countries can gain foreign investment, foreign currencies can flow into an economy, and there are likely to be improvements in infrastructure of all types, from airports to mobile phone coverage.
104
What are the costs of economic growth on consumers
- There is a danger that rapid economic growth could lead to an increase in the rate of inflation.
- If the rate of inflation is higher than the increase in wages then, in real terms, wages would fall.
- An increase in the rate of economic growth may be at the expense of working longer hours, so increasing stress for workers and consumers.
- Economic growth and rising real incomes might not increase subjective happiness after incomes have risen beyond a certain level.
- Economic growth may be associated with an increase in health conditions associated with higher incomes, eg obesity, diabetes.
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What are the costs of economic growth on firms
- Rapid economic growth would cause an increase in demand for workers and raw materials.
- This would cause an increase in wages and in the price of raw materials
- Consequently, firms' costs would increase, which could reduce their profits.
106
What are the costs of economic growth on the economy
On the balance of trade: higher incomes mean that people can afford to import more, and the need of firms to export is no longer so pressing, as higher profit margins can be made through selling at home rather than abroad. Therefore, exports fall, imports rise, and the balance of trade deteriorates.
Evaluation: if there is export-led growth then an improvement of the balance of trade is expected.
On the distribution of income:
- The distribution of income is a measure of the difference in incomes between different groups in an economy. These groups can be measured in a variety of ways but one common way is to compare the highest 10% of income earners with the lowest decile.
- When the economy grows, those who benefit most may be those who are already rich. For example, the manager or shareholders of a business will enjoy the increased profits, whereas other employees, eg cleaners or factory workers, may not receive an increase in wages.
Evaluation: with continued growth, workers may lobby for higher incomes and the rewards may trickle down to those on lower pay. Governments may also have more tax revenues to redistribute to those on lower incomes.
On the environment: with increased economic growth there is frequently an increase in external costs, eg air and noise pollution, overcrowding, social dislocation, and stress.
Evaluation: higher incomes may mean that the government has more tax revenues to clear up environmental damage. For example, subsidies may be given to firm producing electric car or for investment in 'green' technology.
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What are the costs of economic growth on current and future living standards
- In choosing to increase the rate of economic growth, an economy may have to forgo current consumption.
- However, in the future living standards would increase as the PPF shifts to the right.
108
What are the macroeconomic objectives
- Greater income equality
- Economic growth
- Low unemployment
- Low and stable rate of inflation
- Balanced government budget
- Balance of payments equilibrium on current account
- Protection of the environment
However, policies adopted by governments in order to meet any of these objectives are likely to have an impact on the other objectives. Therefore, governments must priorities their most important objectives. Such decisions will determine the opportunity cost in terms of other policies or objectives.
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What are the types of demand-side policy
Demand-side policy is any deliberate action taken by governments or monetary authorities to shift the AD curve.
Monetary policy: the manipulation of monetary variables in order to influence the level of AD
Fiscal policy: the manipulation of government spending and taxation in order to influence the level of AD
110
What are the instruments of monetary policy
Interest rate: is the cost of borrowing money or the reward for saving
Quantitative easing:
After 2008, many monetary authorities found that interest rates alone could not stimulate AD. This was also true during the COVID-19 pandemic because interest rates were already very low. Central banks, therefore, purchased long-term assets in the money or capital markets. As demand for these assets increased, their prices rose, which in turn meant the yield (interest rate) on them fell. Therefore, quantitative easing (QE) has the same impact as cutting interest rates, but it has a direct effect on money markets.
111
What are the instruments of fiscal policy
Government (public) expenditure: refers to spending on areas such as health, education, defence, infrastructure, and welfare benefits.
There are two types of taxation:
- Direct taxes (on incomes), such as income tax and corporation tax. A rise in direct taxes might mean people have reduced disposable income and reduced incentives to work.
- Indirect taxes (on spending), such as VAT. If indirect taxes are raised, the cost of living increases, particularly for those on lower incomes because the tax paid is a higher proportion of their income than for those on higher incomes.
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How would the government use fiscal policy to influence AD
If the government wanted to reduce AD using fiscal policy. It would reduce government expenditure and/or increase taxes. This would have a deflationary (contractionary) effect on AD, with multiplier effects.
If the government wanted to use fiscal policy to increase AD it would increase government expenditure and/or decrease taxes. This would have a reflationary (expansionary) effect on AD, with multiplier effects.
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What is the difference between fiscal deficit and surplus
- If the government spends more than it receives in taxation, this is known as a fiscal or budget deficit. This will lead to an increase in AD.
- If the government spends less than it receives in taxation, this is known as a fiscal or budget surplus. This will lead to a decrease in AD.
114
What is the Bank of England's Role in monetary policy
The Monetary Policy Committee (MPC) of the Bank of England sets the base interest rate.
The MPC meets every month to look at factors that are likely to influence the rate of inflation over the coming 18 months.
At its monthly meeting, the MPC votes to determine whether to raise, lower or leave the base interest rate unchanged.
The MPC is required to use its monetary tools to meet the government's inflation target of 2%. This means that a rise in the average level of prices of 2% if the desired level.
If the 2% target is missed by 1% either side of teh target (ie outside the range 1-3%), the Bank of England is required to explain the reasons why and how it intends to restore the rate of inflation to 2%.
115
What was the Great Depression and what were the policy responses of the US?
The Great Depression occurred from 1929 through most of the 1930s and affected many countries. It started with the Wall Street Crash in stock market prices in October 1929. During this period, countries experience a prolonged recession that resulted in large-scale unemployment.
Policy responses in the USA:
- The initial response of the US Government in 1929 was to do very little. With unemployment increasing rapidly to over 7 million, President Hoover did allow a limited public works programme. He also increased 900 import tariffs by between 40% and 48%, which probably worsened the Great Depression.
- When President Roosevelt came to power in 1933, unemployment had reached 10 million. To address this he introduced his New Deal. This involved a looser monetary policy, millions of dollars for infrastructure, a larger public sector, and price support for agriculture.
Evaluation: some argue that the New Deal, although large, was too little too late, and that it was the money spent on the WW2 that finally led to the end of the Depression.
116
What was the Great Depression and what were the policy responses of the UK?
The Great Depression occurred from 1929 through most of the 1930s and affected many countries. It started with the Wall Street Crash in stock market prices in October 1929. During this period, countries experience a prolonged recession that resulted in large-scale unemployment.
Policy responses in the UK:
- In 1925 the UK returned to the gold standard, which meant that the pound had to be maintained at a fixed value against gold. In order to do this, deflationary policies had to be adopted.
- In 1931, deflationary policies (eg wage cuts in the public sector and tax increases) were necessary to maintain the value of the pound. These further depressed GDP.
- Eventually, in September 1931, the government left the gold standard, which resulted in a 25% fall in the value of the pound. Monetary policy was also eased with a reduction in interest rates.
- The UK introduced a 10% tariff on imports from most countries. However, it cut interest rates and increased money supply.
Evaluation: although GDP rose and unemployment fell, the recovery was uneven. Only with rearmament at the end of the 1930s did the economy fully recover.
117
What was the US policy response to the 2008 global financial crisis
Fiscal policy: tax cuts and increases in public expenditure amounted to around $700 billion.
Monetary policy:
- Interest rates were cut from 5.25% in 2007 to 0-0.25% in 2008.
- Quantitative easing: over the period 2008 to 2010 the Central Bank (Federal Reserve) purchased $2.1 trillion of bonds in an attempt to increase money supply and keep interest rates low.
118
What was the UK policy response to the 2008 global financial crisis
Fiscal policy:
- The government followed expansionary fiscal policy between 2007 and 2010, which included buying shares in UK banks, a temporary cut in VAT from 17.5% to 15%, and bringing forward £3 billion in investment.
- The budget deficit increased from 2.3% of GDP in 2007-8 to 11.3 % of GDP in 2008-9.
- However, from 2010, the UK adopted austerity measures aimed at reducing the budget deficit.
Monetary policy:
- Interest rates: the Bank of England cut the bank base rate from 5.75% in November 2007 to 0.5% in April 2009.
- Quantitative easing: over the period 2009 to 2016, the Bank of England bought £435 billion of government bonds in an attempt to increase money supply and keep interest rates low.
Evaluation:
- The authorities avoided using extreme measures early in the crisis. However, in hindsight this meant that economies suffered more severe recessions than might otherwise have been the case.
- QE may have helped to prevent a more severe recession, but some economists argue that its main effect was to increase asset prices (eg share prices and house prices). However, it did not cause inflation as some had predicted.
119
Strengths of demand side policies
- According to Keynesian economics, demand-side policies are the only way to get a country out of demand-deficient unemployment and stagnation, at least in the short run.
- If the multiplier is large, they can have a significant impact on growth.
- If there is spare capacity, the economy can grow quickly.
- If used to control demand-pull inflation, they can act quickly and solve the problem.
120
Weaknesses of demand side policies
- According to classical economics, expansionary demand-side policies only cause inflation in the long run.
- The multiplier might be so low that they have little effect.
- If there is no spare capacity, then supply-side policies are needed instead in order to achieve economic growth.
- If used to stimulate AD, the government can end up running a huge budget deficit, which adds to national debt.
121
What do supply side policies aim to do
Supply side policies are designed to increase LRAS through measures to increase the productivity and efficiency of the economy. Some of these work through market forces while others involve direct intervention by the government.
122
What are market-based supply side policies
- Increased incentives for workers, eg by cutting income tax rates and benefits for out-of-work members of the labour force
- Labour market reforms, eg reducing trade union power with laws to prevent strikes so that the labour market works more efficiently
- Reduction in corporation taxes (taxes on profits) so that firms have a strong incentive to invest more.
- Increased competition, eg privatisation, deregulation of markets to allow competitors to enter the market, reduction in tariffs (taxes on imports)
- Removing regulations that are preventing firms from growing, eg removing restrictions on mergers to allow these to take place
122
What are market-based supply side policies
- Increased incentives for workers, eg by cutting income tax rates and benefits for out-of-work members of the labour force
- Labour market reforms, eg reducing trade union power with laws to prevent strikes so that the labour market works more efficiently
- Reduction in corporation taxes (taxes on profits) so that firms have a strong incentive to invest more.
- Increased competition, eg privatisation, deregulation of markets to allow competitors to enter the market, reduction in tariffs (taxes on imports)
- Removing regulations that are preventing firms from growing, eg removing restrictions on mergers to allow these to take place
123
What are interventionist supply-side policies
- Improving the skills and quality of the workforce (human capital), eg by providing new vocational courses and apprenticeships.
- Incentives for investment, eg by offering tax breaks for investment or by forcing banks to lend money
- Investment in infrastructure, eg in green transport systems, new mobile phone and internet technology
- Finance for business start-ups, eg in the UK, firms may apply for start-up loans of between £500 and £25,000 to start or grow the size of their businesses.
- Investment in new technology, eg in artificial intelligence, the Internet of Things (Alexa, Google Home), voice technology.
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What are the strengths of supply-side policies
- Economic growth can be achieved without inflationary pressures building up.
- Some supply-side policies help to increase productivity, eg privatisation and deregulation.
- Supply-side policies may be used to achieve economic growth when there is no, or limited, spare capacity.
- They are less likely to cause a conflict with other macroeconomic objectives.
125
What are the weaknesses of supply-side policies
- If AD is very low (ie the economy is operating on the perfectly elastic part of the AD curve) then supply-side policies would have no impact on real output.
- Interventionist policies might be very expensive, eg new infrastructure projects such as HS2
- Many-supply side policies take a considerable time to work, eg improvements in education and training, infrastructure projects
- Some supply-side policies, eg lower welfare benefits and lower income tax rates, might increase income inequality.
126
What is the conflict between inflation and unemployment
The short-run Phillips curve:
When the government tries to control the rate of inflation it is likely to try to reduce AD.
- Less spending will mean less upward pressure on prices
- The government might increase taxes or the MPC might increase rates
- the impact of these may reduce the rate of inflation but they will also mean a fall in AD.
- Firms may start laying off workers because they are unable to sell all their goods and services. As workers are laid off, incomes fall, and so the cycle continues.
- So, there appears to be a trade-off between the objective of controlling inflation and unemployment because in trying to control inflation, unemployment will rise.
This works in the other direction as well.
- If the government is trying to reduce unemployment it might start spending more on training workers or subsiding firms to take on more workers.
- This increased spending in the economy is likely to cause an increase in the rate of inflation
- This is because there is more money chasing the same amount of goods and services.
127
What is the conflict between economic growth and protection of the environment
When an economy grows, standards of living tend to improve.
- However, there may be a conflict between enjoying a non-renewable resource today and someone else enjoying it in the future.
- This is most important when considering those affected by damage to the environment when we consume resources today.
- So, if our increased use of fossil fuels means that there is more global warming, growth may not be as desirable as it first appears.
- Governments must make a choice, weighing up the welfare of today's generation with that of tomorrow to achieve sustainable growth.
128
What is the conflict between inflation and equilibrium on the current account of the balance of payments
Controlling inflation should make a country more competitive internationally and therefore lead to an improvement on the balance of payments.
- Exports become relatively cheap and imports relatively expensive.
- Therefore, controlling the rate of inflation should not conflict with dealing with a balance of payments deficit on the current account.
- However, the actions required to control inflation can damage the current account. For example, raising interest rates to reduce the rate of inflation might have the effect of raising the exchange rate, which in turn makes exports expensive and imports cheap.
- By contrast, contractionary fiscal policy - which might alternatively be used to control inflation - tends to improve the current account because people have less money in their pockets to purchase foreign goods.
129
What is the conflict between fiscal policy and monetary policy
Changes in teh planned levels of spending and taxation by the government (fiscal policy) have a direct impact on the MPC's decision-making (monetary policy).
- If the MPC believes that fiscal policy is too loose, eg government spending is too generous relative to taxation, then it might seek to counterbalance the effect on inflation by raising interest rates.
- If the MPC believes that fiscal policy is too tight, eg government spending is low relative to taxation, then it might seek to counterbalance the effect on inflation by cutting interest rates.
When fiscal policy results in a large budget deficit, this has to be financed by borrowing. Increased demand in the money markets for funds means that there will be an upward pressure on interest rates. In turn, this will increase the cost to the government of borrowing money. However, this may not be the case if quantitative easing causes interest rates to remain low.
130
What is the conflict between monetary policy and supply-side policy
Changes in interest rates and other monetary policy decisions have a direct impact on the costs of firms, therefore shifting the AS curve.
- If interest rates rise, it will cost firms more to produce, which might mean that firms are willing to produce less at any particular price level.
- If interest rates fall, it will cost firms less to produce, which might mean that firms are willing to produce more at any particular price level.
131
What is the conflict between supply-side policy and fiscal policy
Changes in most supply-side policies have a direct impact on government spending, ie fiscal policy. For example:
- Improving education and health services in order to encourage people to be more productive requires high levels of government spending.
- Increasing the length of education also means that governments won't receive money via taxes from income those students might have earned had they been at work.
In most cases:
- Supply-side policies tend to increase the budget deficit in the short term
- Supply-side policies can decrease the budget deficit in the long term, as improved human capital means higher incomes that can be taxed by the government.
However, some supply-side policies, such as reducing bureaucracy, are unlikely to make a significant impact upon government spending (G) and taxation (T).
Some supply-side policies, such as privatisation and cutting benefits, tend to reduce the budget deficit. Privatisation is a one-off benefit, and cutting benefits could increase long-term costs to teh government because of the social problems involved.
